Extending Credit – How Firms Quantify the Net Effect of Switching from Cash in Advance Terms to Open Credit Terms

By Jay Karimi

So your company is considering extending net 30 day terms to your customers instead of requiring them to pay for their orders in advance or on delivery?  There are a plethora of costs that will be incurred as a result of this switch, such as, the cost of hiring a full time credit and collections manager, the cost of bad debt (you won’t collect 100% of your receivables), cost of short term financing, and the opportunity costs.  With this onslaught of additional expenses, is switching your credit policy worth it?  

YES!

 That’s the short answer; the long answer is that the customers buy considerably more when they don’t have to pay right away.  As long as you have an effective credit and collections department and access to reasonably priced short-term financing, selling on credit terms is your best bet.  If you’re skeptical, here’s mathematical proof:

            NPV = - (C/r) + [(AR / r) x (1 – d)]

where, AR = additional revenue, d = probability of default, r = required return and C = cost of credit policy

To flesh out this formula, let’s assume LazyMan Film Equipment Rentals will experience a 20% increase on its $1 million annual sales when it switches to an open credit policy.  They will hire a full time credit and collections manager for $55,000 a year plus $10,000 in her benefits and employment taxes.  There will also be $5,000 a year in corporate credit agency subscriptions.  The industry average yields a 5% default rate and 2% required return. 

Annual sales w/o credit = $1,000,000

Annual sales w/ credit = $1,200,000 (20% bump)

Additional sales = AR = $200,000

Probability of default = d = 5%

Required return = r = 2%

Cost of credit policy = C = $70,000

Plugging in the numbers into our formula provides:

NPV = -(C / r) + [(AR / r) x (1 – d)]

       = -(70,000/.02) +  [(200,000/.02)  x (1 - .05)] 

{Note: both the additional annual revenue and annual cost of the credit policy are treated as annuities from the current year until forever}

       =  6,000,000

The firm should pursue an open credit policy because it is worth $6 million in today’s dollars (Recall that firms should accept any project with a positive net present value since it will ultimately add value to the shareholder). 

To calculate at what point the probability of payment default is too high to pursue an open credit policy, we can set the above equation to zero and solve for d:

0 = -(70,000/.02) + [(200,000/.02) + (1 – d)]

d = 6.5/10

d = 65%

In conclusion, as long as you expect to collect at least 35% (1 – 0.65) of your account receivables, this project will have a positive net present value and should be pursued.